A bubble in a financial market usually describes a situation when prices for a particular asset or in a whole market rise exponentially during some period of time, and this growth cannot be explained by fundamental factors. After such rapid growth, the price will eventually fall down, and this fall tends to be much faster than the previous growth was. Bubbles can occur in all markets, and any asset may be subject to a rapid inflating of the price and the subsequent explosion of the bubble.
It is not always possible to timely detect bubbles and relocate capital if it is invested in such inflated assets. Moreover, it is typical for the human nature to be willing to earn more despite cautions and some early signs of threats. However, the consequences of greed can be much more costly that the potential profit. Therefore, it is feasible to pay attention to some early signs of bubbles and try to protect your capital.
1. Inadequate market value
The most evident sign of a growing bubble is a significant discrepancy between asset’s market price and the price predicted by fundamentals. The market may trust in bright perspectives of an asset and value them despite the currently weak performance. And this may be fair expectations as the performance may improve quickly. However, when this lasts long, it is feasible to believe to the fundamentals rather than market expectations. Of course, you may draw a lucky card and beat the market by holding an asset till its growth or investing at an early stage when the market does not expect an asset price to rise significantly. However, the chance of beating the market phantasmal while the chance to lose is much more tangible. Even if an asset is overvalued, there should be an explanation of such market trust. These can be the forthcoming changes in legislation, the development of a new game-changing technology which is about to be implemented or transformations in the infrastructure that will lead to the price growth. If you cannot find such potential changes and the expectations are based only on the faith or unconfirmed talks, it looks that an unsubstantiated increase in price will be followed a faster dropdown.
2. Subsidies and legislation changes
Legislation changes and government activities may contribute to the bubble inflation as well. When the underwriting mortgage rules had been relieved in the early 2000s, this was the first sign that mortgages would become more affordable. On the one hand, this was necessary for the growth of the US construction market, but on the other hand, an increase in the number of impaired loans could be expected as well. Along with other factors, such as the lack of control, greed of investment bankers and connivance of rating agencies, this led to the US mortgage market and the following global recession. Another example is the quantitative easing measures designed to fight with the Covid-19 consequences. A drastic increase in liquidity entailed rapid growth of the stock market, but when these liquidity injections were stopped, the equity price bubble, especially in the high-tech sector, burst. It does not mean that any legislation changes will lead to a bubble growth. But if you decide to invest in a particular sector, it is feasible to explore what consequences governmental activities may bring.
3. Asset price increases despite the news
The first sign to think of in the light of the potential existence of a bubble is when an asset price increases regardless of the arriving news. A quarter profit of a company appeared to be lower than expected? Does not matter, its stock price is growing. Lower output? They have been accumulating reserves, and the next period will be much more successful. Scandals? These are competitors’ machinations through corrupt media.
Let us be honest. If news does not influence the stock behaviour, this is a reason to think objectively. The efficient market hypothesis that has been ruling the academic finance over the last 50 years, claims that the market is efficient. This means that the asset price instantly absorbs any news that is directly or indirectly connected with the asset and can potentially influence its price. Ideally, any moment you see the asset price, it already contains all the available information. And the logic of the price behaviour is simple. If the news is good, the price is rising, and vice versa, bad news makes the price fall as in this case, investors have less trust in an asset.
However, if the price is constantly growing regardless of the kind of the news, this means that there are some hidden factors or forces that push the price up. If they are not explicit, this likely means that someone wants to conceal them and pursues their own goals. Typically, this is the goal to involve as many investors as possible and thus increase the asset price, but there may also be other goals. Once these goals have been achieved, the asset price will likely fall down.
4. Permanently good news for a long time
The second factor that should make an investor to be suspicious is if there is only good news about an asset and its perspectives coming over a long period of time. The prospects of an asset may be really bright, but it cannot be that everyone in the market has the same opinion. There will always be conservative investors and analytics who will be cautious regarding the expectations on new assets as well as those who will be merely sceptical. Of the market sees only good news, bad are likely to be hidden or suppressed. This is also a sign that the asset price is being manipulated and the bubble is being inflated artificially. Similar to the first sign, someone should be interested in hiding news and stimulating fast asset price growth. This manipulation cannot last forever, so the price will ultimately fall.
5. Story that captures the investors’ minds/the next big thing
Not only manipulations can be a reason behind investors’ blindness. The world periodically gives birth to very colourful stories that look to have no other ending but a happy end with international fame and multi-billion capitalisation. An amazing breath-taking story is one of the best instruments to create a bubble. People are sentimental, and even investors are not always rational but tend to allow feelings to dominate their decisions.
Each of these stories promises to change the world and make it much better than it was before. This dream may come true, but you might need much more time to benefit from investments in such stories that you expect. Internet and the following dotcom boom of the early 2000s seemed to be a game-changer. Indeed, the internet has transformed our lives dramatically so that there are very few people who would voluntarily refuse from using the web. But before this happened, a half of the IT companies had failed in the market thus clearing the field for the survivors. Uber seemed to have come to transform many service industries and bring a seller and a customer together directly. However, although many industries such as taxi services, car sharing, food and product delivery have indeed been reformed, Uber itself continues to be unprofitable. Capital holders should think carefully before investing such a unicorn whatever it promises. While early investment may make you rich, there is a larger chance to succumb to hype and lose everything. If so, how is it different from a casino game?
6. Newly coming investors say that olds ‘do not understand
IT progress promises a brave new world. Younger populations turn into advocates of new technologies and claim that old people do not get it. Many of elderly hardly master smartphones while those under 30 years old cannot imagine the life without gadgets. Therefore, when a potentially next big thing comes to the market, they believe that this is what will make them rich easily. They listen to only good news and ignore precautions. They get rid of stocks of real-economy industries. They expect that cryptocurrencies will ultimately conquer the world and think that they have chosen the rocket will get them right to the moon while the blockchain technology will be utilised in every product. These voices were especially loud in 2017 and 2021. However, the time passes by, and they can see that cryptocurrencies are another speculative asset that can be easily manipulated by market makers while Warren Buffet remains the richest world investor. The world is changing, but it is naïve to think that it changes rapidly. It is even more naïve to think that you understand more than the others.
7. A point on the descending lifecycle line
When estimating whether an asset is overvalued or not and trying to predict its future market prospects, it is always useful to look at the stage of the economy and business cycle. The matter is that while the prospects may seem bright, objective factors may suggest that the entire market is coming to a descending period of the cycle so that it will be very difficult for a company to succeed. It may occur that while a company is trying to grow, the objective macroeconomic or technological factors will be pushing it down. It is not that the cyclicity will be the main driver behind bubble growth, but it may play a role as well.
Author bio
Catherine Smith is an online Marketing Manager at PhD Centre, specializing in PhD thesis writing. She is passionate about researching and writing on various topics, including Education, Marketing, and Technology.
